|Market failure describes the circumstances in which distortions prevent the invisible hand from allocating resources efficiency. It covers all the circumstances in which equilibrium free unregulated markets i.e., markets not subject to direct price or quantity regulation by the government. The following sources of distortions can lead to market failure.
- Externalities can be caused by the acts of individuals or by acts of institutions. For example, music clubs in students’ hostels are often accused of playing loud music, disturbing the peace that ought to prevail at night.
- When externalities are generated, there arises a question that ought to own the property. In the example still plant, there always arises a question who should own the ‘clean water.’
- Externalities can be positive and negative.
- Externalities, especially the negative externalities, cannot be done away with. For example, if we aim for one hundred percent clean air, there can be no factories and no production. A balance has to be struck between the benefits and costs of the activity before imposing restrictions.
- Non-rival: Public goods are non-rival in nature. A good or service is non-rival if, even on consumption by some individuals, the quantity available for others is not reduced. The classic example of a service which is non-rival is the defense services. We do not get this character in private goods. For example, the purchase of a pair of shoes by one reduces the availability of shoes for others. This is because the marginal cost of providing shoes for an additional consumer is positive. Rival goods, therefore, get allocated to consumers, but in the case of non-rival goods, no such allocation is made, and they are available to everyone.
- Non-excludable: Unlike, private goods, public goods are non-excludable i.e., people cannot excluded from the consumption of such goods or services.
- Emissions standards: An emissions standard is a legal limit on how much pollutant a firm can emit. If the firm exceeds the limit, it can be monetary and even criminal penalties.
- Emissions fee: An emissions fee is a charge levied on each unit of a firm’s emissions.
- Transferable emissions permits: Transferable emissions permit is a system of marketable permits, allocated among firms, specifying the maximum level of emissions that can be generated. If we knew the costs and benefits of abatement and if all firm’s costs were identical, we could apply a standard. Alternatively, if the costs of abatement varied among firms, an emissions fee would work. However, when firm’s costs vary and we do not know the costs and benefits, neither a standard nor a fee will generate an efficient outcome.